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Microcap stocks are at it again. The smallest 3% or so of the market is beating the S&P 500 for the third time in four years. Just as in technology, tiny can be very appealing.

Unlike technology, though, where newer is often better, investing in microcaps is better done through a good ole' fashioned mutual fund. While index ETFs that focus on large companies have beaten their actively managed fund counterparts for years, microcap mutual funds are consistently ahead of their ETF rivals. Two-thirds (26 out of 38) of mutual funds have beaten comparable ETFs over the past three years, according to Morningstar data. The most heavily owned microcap ETF,
iShares Russell Microcap IndexIWC 0.359553149833007%iShares Micro-Cap ETFU.S.: NYSE Arca87.1422
0.31220.359553149833007%
/Date(1481301004425-0600)/
Volume (Delayed 15m)
:
6065
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
0.8084440323513481% Rev. per Employee
N/AMore quote details and news »IWCinYour ValueYour ChangeShort position
Fund (ticker: IWC), has a five-year annualized return of 6.3%, better than the S&P 500 but behind popular mutual funds like
DFA US Micro Cap I
(DFSCX) and
Bridgeway Ultra-Small Company
Fund (BRUSX). These funds gained an annualized 9% over the same time frame, better compensating investors for the risk of owning small, often untested companies. "Microcap ETFs are doomed to disappoint," opines Morningstar analyst Samuel Lee, a passive-investing enthusiast who nevertheless views the method as ineffective for microcaps.

HERE'S WHY: Stock ETFs tend to thrive in markets where liquidity and trading volume are deep. But in microcaps, heavily traded stocks are the most overfished, so they trail others in the category—badly. A recent Yale study found that the most-liquid quartile of microcaps returned an annualized 1.32% from 1972 to 2011, versus 15.36% for the least liquid ones. This turns the normal advantage of indexing on its head. It also creates a chance for active managers to prosper.
AllianzGI Ultra Microcap
Fund (AUMIX), for instance, looks for stocks whose market capitalization is less than two times the weighted average of the Russell Microcap Growth Index. This fund has a five-year annualized return of 17.4%. ETFs can't come close.

Hidden trading costs can hold back ETFs even further. When a change to a widely followed stock index is announced, traders can step in to buy shares before they enter the benchmark, driving up the price. While it doesn't matter much for large stocks, the cost baked into funds tracking the small-capitalization Russell 2000 index was anywhere from 38 to 77 basis points or more annually from 1990 to 2005, according to research by Antti Petajisto, an academic since hired by BlackRock. Ned Davis Research analyst Neil Leeson last year identified the iShares fund as one of a handful of ETFs with the potential to spur exaggerated, if temporary, price swings in some illiquid stocks.

The liquidity disadvantages and trading costs are analogous to what's seen in thinly traded international small-company stocks, where the biannual S&P Indices Versus Active Funds (better known as the SPIVA) study finds that more than 75% of international small-cap mutual funds beat the index in the past five years. You're witnessing the last corners of the stock market where active management works best.